Should I Invest in a 401k or Roth IRA?

Should I invest in a 401k or Roth IRA? This is an excellent question because it not only shows that you are thinking about investing, but also that you are willing to devote extra thought as to where your money actually goes. After all, devoting more attention towards investment and retirement, can equate to retiring earlier or with a much larger sum of money.

Now back to the question, should you invest in a 401k or Roth IRA? There is no easy answer, but I’m going to try to simplify it as much as possible so that you can make an educated decision. Let’s look at the two options and see what the considerations are:

401k and traditional IRA accounts are tax deferred accounts. Money that goes into these accounts is taxed later when it’s withdrawn. Some benefits of these types of tax-differed accounts:

Reduces the taxes you pay today

Invest money that you would have otherwise paid in taxes

Taxes on gains are also differed

Drawbacks of these type of accounts:

Money will be taxed as income when withdrawn

Money is not accessible without penalty before 59 1/2 years of age

In contrast, money deposited in a Roth IRA is post-tax. That is, you pay taxes first, then deposit the money. When the money is withdrawn later, it comes out tax free. Here are some benefits of a Roth IRA:

Investments grow tax free

Money withdrawn after 59 1/2 years old is tax free

Here are some drawbacks:

Does not reduce your tax liability today

Money is not accessible without penalty before 59 1/2 years of age

Many suggest that a Roth IRA is better for younger investors who often have very low tax rates and a long time for investments to grow. The logic being two fold: The money you save when your tax rate is low is obviously low. Given a long investment horizon the gains will be high, therefore the taxes saved later will be high.

On the contrary, many suggest for older investors that the 401k or traditional IRA may be better since your tax rate may be high and therefore the tax savings is also higher. Additionally, there is less time for the investment to grow, so the later tax savings will not be as high.

So which option is better?

An interesting article by Retireby40, shows a more visual side by side comparison of investing in a 401k versus a Roth IRA, these were the assumptions:

The investor is in the 25% tax bracket and can invest $5,000 in Roth IRA or $6,666 pre tax in 401k.

8% annual gain

Investor retires at 60 and lives until 80.

Withdrawal rate is (total money left / years left to live.)

After retirement, his income is derived solely from this portfolio, thus he has lower tax rate. This is a big assumption, but mostly valid. Most retirees make less money after they retire and pay less tax annually.

As you can see in the chart above, the 401k portfolio grew to a much greater total than the Roth IRA ($815,558 vs. $611,668).

When focusing in on the withdrawal period from age 61 and beyond, the 401k appears make more sense.The 401k investor can withdraw $40,778, and receives a total of $34,457 after tax on this income. The Roth IRA investor can withdraw $30,583, keeping the entire amount.

The difference in this particular scenario is about $4,000 per year or 10%, but it assumes that the tax code will stay the same as it is today. Some predict much higher taxes in the future, these individuals tend to favor the Roth IRA, since it will be tax free when it’s withdrawn.

What can you control?

Although there may not be a clear cut answer in the 401k vs. Roth IRA debate, you should make sure you take advantage of what you can control. If your employer has any kind of 401k match, you need to capitalize on this! Take advantage of FREE money, otherwise you are missing out on a big opportunity to boost your retirement savings.

What is your opinion? Do you think it is better to invest in a 401k and pay tax later, or invest in a Roth IRA and pay tax now? In my personal opinion I started investing in a Roth IRA at the age of 19 and figured that even in retirement I would still be looking for ways to make additional income! I wanted to pay taxes upfront so that I can have a large sum of tax free money waiting for me when I retire.

Haha agreed Eric. Remember though, you also want to have money on hand to enjoy the present because the future is never guaranteed. An aggressive approach at a young age is a great idea, but make sure you also enjoy your youth!